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Chapter 12 of the 5th Edition PMBOK® Guide covers Procurement Management, and the first process 12.1 Plan Procurement Management has as its main output the Procurement Management Plan, which sets out the guidelines, policies, and procedures for conducting, monitoring and controlling, and then closing the procurement process.

The very first tool & technique of the process 12.1 Plan Procurement Management is the Make-or-Buy Analysis. If the decision is made to do all the project work in-house, as opposed to purchasing some components of the project work from outside sources, then there will be no procurements. In a way, you can say that the knowledge area of Procurement Management is the only optional knowledge area in that it is conceivable to have projects that do not require procurement management during the course of the project.

But even so, in the planning stage, it is necessary to plan for the possibility of procurements unless it is absolutely certain from the scope of the project that they are not going to be needed. How do you know whether the possibility becomes a certainty? Through the Make-or-Buy Analysis.

2. Make-or-Buy Analysis: Direct and indirect costs

The costs of producing the component of the product in-house are compared to the costs of having the component produced from outside sources. PMI stresses the important point, however, that both direct and indirect costs must be considered. The direct costs are those of making or acquiring the product, and the indirect costs are the support costs for the product.

For example, if you buy a software package from a company, you need to consider the support that this software package will require, in terms of training for the team members who will use it, the necessity for upgrades, and the “help desk” required for team members who have questions regarding its usage.

Another indirect cost is the cost incurred if the quality of the component does not conform to specifications, either those set by the company (i.e., some components lie outside the control limits) or worse, those set by governmental regulations (i.e., some components lie outside the specification limits). These costs of non-conformance may include

the costs of scrapping the non-conforming components or repairing them or the warranty and product liability costs if the non-conforming components are caught in the inspection process

the costs of warranty or product liability claims and/or lawsuits if the non-conforming components are not caught in the inspection process and are passed on to the consumer

For this reason, a high-risk component (such as the airbags in an automobile) might be best left to a company that has specialized knowledge in producing them. In a way, procuring high-risk components rather than producing them in-house is one form of risk response called risk transfer (purchasing insurance is yet another form of risk transfer).

3. Make-or-Buy Analysis: Purchase vs. Lease

If a company decides to buy a product rather than make it in-house, then another level of decision must be made, whether to purchase the product, result, or service outright or whether to lease it from the seller.

4. Make-or-Buy Analysis: Cost Risk

In describing the make-or-buy analysis, PMI uses the phrase “risk sharing between the buyer and seller”. In order to avoid confusion between this kind of risk, and the risk I mentioned in paragraph 2 as one of the possible indirect costs associated with purchasing a product from a seller, let me refer to this first type of risk as “cost risk”.

How does this differ from regular risk? To answer that question, let’s go to the textbook definition of risk: an uncertain event or condition that, if it occurs, has a positive or negative effect on one or more project objectives. If one of the project objectives is considered producing the overall product within the allotted budget, then the cost of purchasing a component of the product from a seller has a cost risk, i.e., the risk that the actual final cost of the component may differ from what the initial budgeted cost is for that component. And this is where the contract type comes in. In a previous post, I outlined the three types of procurement contract, a) fixed cost, b) cost-reimbursable, and c) time & material contracts.

In fixed cost contracts, the cost risk is borne by the seller, since if the final cost of the component differ from the initial budgeted cost, then the seller is only paid the initial budgeted amount, and the seller will end up producing the component at a loss.

In cost reimbursable contracts, the cost risk is borne by the buyer, since if the final costs of the component differ from the initial budgeted costs, then the buyer pays the seller the final costs. The seller will end up producing the component at a profit, but the buyer is now over budget on the project.

The “uncertain event or condition” in this case has an effect on the cost objective of the project. However, there are other types of risk to the project, for example, the risk that the schedule objective (the deadline) or the quality objective (meeting all technical requirements) that need to be considered in the make-or-buy analysis. There are ways of modifying the fixed cost or cost reimbursable contract so that not just the cost risk, but the overall risk is shared more equally between the seller and buyer. This is done by offering fees, awards, or other incentives for the seller to produce the product not just within the budgeted amount, but on time and in conformance with the buyer’s scope requirements.

5. Conclusion

The three most important concepts to remember when it comes to the make-or-buy analysis are the following:

to compare the cost of making the component in-house vs. purchasing the component from outside the company, you need to consider both the direct costs and the indirect costs (cost of ongoing support for the component, cost of nonconforming quality, etc.)

if the make-or-buy analysis leans towards “buy” rather than “make”, the type of procurement contract will depend on how the risk is to be shared between the buyer and seller; fees, awards, or incentives can be specified in the procurement contract as ways to make the risk sharing more equal between the two parties

in considering the risk, you need to take into account the cost risk (risk to the cost objective of the project, i.e., whether the final cost of the component will exceed the initial budgeted cost for that component), as well as the other types of risk (such as risk to the schedule, scope, and specified level of quality).

The output of process 12.1 Plan Procurement Management is the Procurement Management Plan, and the next post will outline the various elements that this plan entails, and how these elements relate to the other 9 knowledge areas involved in project management.